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The Economics of the Financial Crisis


Cheap money: the build-up of world-wide ... Fifth insight: cheap money ... large: no real expenditures, but flight to assets: housing, equity, commodities ... – PowerPoint PPT presentation

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Title: The Economics of the Financial Crisis

The Economics of the Financial Crisis
Elmer Sterken

Unique event.
  • This financial crisis is unprecedented
  • Hopefully a once in a lifetime experience
  • First serious economic problem in this part of
    the world since 1979-1982
  • We are right in the middle! And should be
  • So our Faculty of Economics and Business pays
    attention to the Financial Crisis
  • Today is the first session, next week Professor
    Harry Garretsen, our expert in financial crises,
    will continue!

Overview of today
  • A Brief History of the financial crisis
  • Main mechanisms the economics of the current
  • A view on the core of banking fragility
  • Real impact transmission of financial
    disturbances will the real economy suffer? And
    how does it work?
  • Predictions, speculations, and policy advice
  • I speak for about 45 minutes after that
    everyone is free to go, but I will be happy to
    discuss remaining items

History of the 2006-2008 crisis
  • The current financial crisis started with the
    sub-prime crisis in the US. There is no precise
    starting date, but it is around the end of
    2005/beginning 2006
  • The main cause is the risky mortgage market
    structure (sub-prime loans and adjustable rate
    mortgages) and decreasing US house prices
  • This sub-prime crisis triggered a larger crisis
    of the banking/financial sector itself
  • First, lets look at the problems of sub-prime
    lending and the US housing market

Sub-prime lending
  • Financial institutions providing credit to
    borrowers that have a heightened perceived risk
    of default (history of loan delinquency or
    default, recorded bankruptcy, or limited debt
  • Sub-prime lending includes a variety of credit
    types mortgages, auto loans, credit cards
  • But, in 2006 about 60 of all sub-prime borrowers
    had credit scores high enough to qualify for
    prime loans!
  • The value of US sub-prime mortgages was estimated
    to be 1.3 trillion US as of March 2007 (7.5
    million contracts) total US mortgage market is
    about 12 trillion US in size

Adjustable Rate Mortgages
  • Mortgage loans where the interest rate is
    periodically adjusted based on a variety of
    indices (mostly the money market rate)
  • 16 of sub-prime loans where ARMs with 90-days
    delinquent or foreclosure procedures. By May 2008
    the delinquency rate was 25
  • Especially in a downturn ARMs can enforce
    negative dynamics
  • What causes the downturn decreasing housing

Case-Shiller Housing price US
Regional differences
Initial impact on US financial institutions
  • Drop in the value of assets like mortgage-backed
    securities (MBSs)
  • MBS cash flow is backed by the principle and
    interest payments on a set of mortgage loans. In
    most cases packages of mortgage loans were
    securitized in so-called special purpose
  • Lot of banks (about 8400 in total in the US) had
    speculated on an increasing house price. They
    used financial leverage borrowing against a low
    rate and invest the money in risky equity/other
  • No real intensive supervision by the SEC/FDIC or

Expansion of the crisis
  • Investors pulled back out of the mortgage loan
    market and invested in e.g. oil contracts/other
    raw materials/ speculative contracts
  • Banks became unwilling to lend to other banks
    inter-bank money markets failed to work
  • Other assets, like Commercial Paper became
  • International linkages between banks spread out
  • Stock market indices decreased worldwide
  • Trust in debt markets lowered and most in
    particular trust in the banking sector decreased

Over-The-Counter derivatives BIS-data
(billions US dollars)
Steep increase after 2005
Credit default swaps
  • Two agents B and C transfer the credit risk of
    agent A. How does this work?
  • Suppose company A issues a bond with a return of
    10. Agent B owns this bond, but dislikes the
    default risk of company A.
  • Agents B and C use a CDS B pays a fixed amount
    of the principle of the bond, and C carries the
    burden of default risk and repays B if default
  • This is a market that banks used to trade risks!

OTC credit default swaps (BIS, billions US
Enormous increase
No data available
Seven Economic Insights we need
  • Private nature of loans and opaque balance sheets
    of banks
  • Trade-off between stability and efficiency
  • The conquest of the capitalist system market-
    versus bank-based economies and remuneration
  • Speculative bubbles
  • Cheap money the build-up of world-wide liquidity
  • Knut Wicksell overinvestment theory
  • Trust

First insight private nature of loans
  • Private contract single supplier and unique
    buyer. Could be a solution to market failures a
    private contract is a typical banking product
  • Elements to contracts (1) interest rate, (2)
    terms of maturity, (3) other repayment
    obligations, (4) collateral (think of real estate
    in mortgage contracts)
  • Private nature of the contract value of the
    asset is opaque to other market participants
  • This is precisely one of the banking problems!

First insight banks balance sheets
Money/Capital market sensitive
Stock market sensitive
Second insight trade-off
  • Important trade-off that we face in the banking
    industry efficiency versus stability
  • We want banks to be competitive, looking for
    large profits. But we also want banks to stable.
    There is a clear trade-off
  • In the Anglo-Saxon market economy the emphasis is
    on efficiency in countries with other
    institutions, stability is more important

Third insight conquest of capitalism and
market-based versus bank-based
  • Since 1989 the capitalist system has no real
    opponents liberalization and internationalization
    are fully developed especially in finance
  • Market-based economies e.g. US and UK. Market
    capitalization is high, private markets are
    smaller, bank loans are less important,
    short-term contracts dominant
  • Bank-based economies e.g. Japan, Germany. Market
    capitalization low, large private markets,
    long-term bank-relations (Hausbanks)

Fourth insight speculative bubbles
  • Suppose we have an asset a with a price p and
    demandat ? (Etpt1 - pt). Et is an
    expectations operator
  • Suppose there is a fixed supply process
    at K, so independent of
    time t
  • We assume rational expectations all market
    participants know the information in the market.
    The price solution has the form pt B (K/?) t
  • B can be anything! So multiple price processes
    are consistent in case of agents with rational
  • If I believe that you believe that your brother
    believes. The stock price can increase without
    any fundamental cause

Fifth insight cheap money
  • Greenspan probably has increased liquidity too
    much between 2003 and 2005
  • Other economies had to follow this policy via
    fixed exchange rates
  • Also the ECB has had a too large M3-growth rate
    after 2002
  • Conclusion liquidity growth has been too large
    no real expenditures, but flight to assets
    housing, equity, commodities

US Federal Funds Rate Taylor rule
Taylor-rule implied rate above the actual rate
Money growth in Europe
Excessive growth
Excessive growth
Target 4.5
Sixth insight Wicksells overinvestment theory
Investment over the top Interest rate too low
Seventh insight trust
  • Money is a product of trust
  • Banks are products of trust
  • Trust is asymmetric it takes a long time to get
    it it can be lost at a high pace
  • Trust can be a substitute for financial
    contracts. If I lend my friend 10 euro, I dont
    need a contract (at least I hope so)

The core of the banking problem
Trust in liquidity insurance
  • Idea consumers are uncertain about the timing of
    consumption and invest their funds at the bank in
    a deposit as an insurance
  • Banks are a pool of liquidity they should
    provide liquidity when needed
  • If households vary in risk profiles, banks do not
    need to hold full cash (reserves) for deposits
  • But consumers face liquidity shocks
  • This model is the Diamond-Dybvig-model

How does Diamond-Dybvig work?
  • We have two groups of consumers
  • Group 1 is patient hands in deposits at time 0
    and returns to the bank at date 2
  • Group 2 is impatient they return at date 1
  • As long as the bank knows how large group 1 and
    group 2 are no problem
  • They hold cash for group 2 and invest in a
    long-term, but risky, project, and payout a
    higher interest to the patient group 1 (this is
    the first equilibrium outcome it is a good

But there is a second, bad, equilibrium
  • If all depositors believe that this solution
    works no problem. The bank will function
  • But, suppose that a patient consumer (group 2)
    anticipates that all other patient consumers will
    withdraw at date 1 (liquidity shocks). The bank
    will be forced to liquidate the long-run
    activities early
  • There will be no capital at date 2 and the
    rational depositor will withdraw at date 1

The causes of instability
  • If the relative return of date 2 deposits is less
    than an opportunity return, depositors will
    withdraw early
  • There might also be mistrust in the capabilities
    of the bank (or management of the bank)
  • There might be negative signals about the bank a
    consumer sees this as a liquidity shock

Solutions to instability 1 narrow banking hold
enough reserves
  • A bank needs enough liquidity to guarantee
    repayment to all depositors even in the case of a
    bank run
  • A bank obtains enough liquidity after liquidation
    of its long-run investment technology
  • A bank obtains enough liquidity after
    securitization of its long-run technology
  • Anyhow, all these options are likely to be
    unattractive, due to low profits

Solution 2 suspension of convertibility
  • Suspension of convertibility. If the proportion
    of impatient consumers is known, the bank
    announces that it will serve only the
    pre-announced repayment at date 1. After this
    threshold convertibility is suspended. This is
    the initial ICESAVE-case

Solution 3 Deposit insurance
  • Banks create a deposit insurance company,
    contribute the premium
  • The central bank can help in extreme cases
  • Discussion on the maximum amount to be insured
  • Main problem moral hazard. If banks know that
    deposits are insured, they will go for riskier

Solution 4 equity
  • A bank can try to attract more equity. If private
    markets dont work, the government can supply
    capital. This is the FORTIS case
  • A major drawback is that a nationalized bank
    disturbs competition. Some people advocate full
    nationalization to avoid a domino-effect
  • But, both investors and banks are dependent on
    market beliefs

Conclusion liquidity insurance
  • We want banks to transform deposits into loans
    this leads to optimal welfare. We also want
    knowledge about the loans to be WITHIN THE BANK
  • This equilibrium is risky. Both the good and
    bad solutions are rational
  • Regulation should help to keep the banking model
  • Universal banking, or bankinsurance, or
    investment banking activities, can blur the
    liquidity insurance idea

How can banking problems spread out in the real
economy? Main arguments
  • If financial assets are imperfect substitutes
    bonds and loans (or public and private contracts)
  • If internal wealth becomes low external
    financing premium will increase. Especially the
    interaction is nasty
  • If assets are used as productive assets and
    collateral houses and land reuse of financial
    assets as working capital
  • If financial leverage varies a lot between
    agents some classes of firms and households are
    affected more than average

IS-LM lower income
Interest rate
Money market equilibrium
Monetary contraction
Real equilibrium
Bernanke modern versions of debt deflation models
  • Internal wealth affects current spending
  • Lower internal wealth will increase the so-called
    external financing premium (think of risk spreads
    on private bonds)
  • The combination of a general cost increase,
    higher leverage, and so higher EFP, will slow
    down demand
  • Information problems cause this interaction
    between costs and leverage

Bernanke IS-LM
The empirics of the financial crisis part I
summer 2007-august 2008
  • Main focus on the US estimates of the impact of
    foreclosures and house price decreases on
  • Two main channels (1) costs, (2) wealth effects
  • The cost channel is relatively unimportant. The
    user cost of capital elasticity of investment is
    about -0.25, for consumption almost 0
  • So it is the wealth effect

Wealth effects so far in the US
  • Mean wealth in houses in total private wealth is
    about 30 median wealth about 70 median
    loan-to-value is 80. So about 10-15 of total
    private wealth is in housing
  • In March 2008 about 11 of the households had 0
    equity in housing potentially about 30 could be
    in this group. This implies that about 3 to 4.5
    of total private US wealth could be lost
  • Given normal relationships between wealth and
    consumption about 1 to 1.5-point consumption
    growth could be lost this is the case in 2008!

What can we expect? Part II August 2008-?
  • US growth will at least slow down to about 0 in
    2009 (see the World Economic Outlook 2009 of the
    IMF). Note Iceland -3!.
  • Janet Yellen (San Francisco FED) predicts
    negative growth rates in 2008.3-2009.1. The US
    economy starts its recession right now. So it is
    more likely that growth rates will turn negative
    to about -1/-2
  • Europe will follow contraction might even be
    stronger due to higher rates of indebtedness and
    lower flexibility of labor and goods markets

  • Return of trust (1) lower money market rates by
    at least 100 basis points goal is to lower
    costs, (2) through that increase liquidity
    further by supporting inter-bank markets (the
    current EU-initiative), (3) buy
    equity/nationalize some banks (not all),
  • Future supervision should be improved (1) start
    of a European/maybe worldwide bank supervisor,
    (2) end of universal banking, (3) cope with moral
    hazard issues, (4) end of market-based (fair
    value!) accounting, (5) limit the use of
  • Fiscal policies should support financial and
    monetary policies. To avoid a recession taxes
    should be lowered